Many people imagine what they would do with a million dollars. But there are a number of situations that require a person to go through this thought process in reality — one is through an inheritance. An inheritance can come in many forms: life insurance proceeds, retirement accounts, investment assets or checking and savings accounts, to name a few.
Though an inheritance may sound like a blessing, the result can sometimes be the exact opposite. Studies have shown that regardless of the circumstances, a large majority of people who come into an inheritance experience “sudden wealth syndrome”, which is characterized by confusion, anger, sadness or a combination of all three.1
If you become the beneficiary of an inheritance, you may be confronted with important, immediate decisions about how to best manage your windfall — decisions that you may not be prepared for or ready to face.
Here are three rules of thumb that can help you get the most out of your inheritance and avoid making decisions that you may regret.
The first thing you should do upon receiving an inheritance is simple: don’t do anything. Whether the amount is small or large, chances are that your inheritance will be unexpected. As emotions tend to run high in these situations — often, the inheritor is still grieving from the loss of a family member or loved one — it’s common for many beneficiaries to wipe out their inheritances in the blink of an eye.
Rather than quit your job or buy a new sports car at the first opportunity, take a step back and think about your goals. The most invaluable piece of the puzzle is seeking the assistance of a qualified financial professional, particularly for those who are not used to managing large sums of money. An advisor can help you develop a clear understanding of how your inheritance affects your current and future financial situation.
An advisor can also help you develop a plan of action for moving forward. A plan is of the utmost importance when an unexpected windfall comes into the picture. In order to fully process your new financial position and prioritize your goals, the first step is to put your inheritance in a safe place. Instead of depositing liquid cash into your personal checking account, consider putting the monies into an FDIC-insured money market deposit account (MMDA) or a certificate of deposit (CD). The FDIC insures up to $250,000 per covered account.
As an inheritor, it’s important to recognize your own limitations in handling the financial details of your inheritance. Most importantly, you should seek out a tax advisor and financial planner to help you make sense of your sudden windfall. A professional will be aware of the various tax implications that surround inherited property. Although the value of inheritances is generally excluded from gross income, any production of income attributable to the funds (dividends, interest, etc.) is taxable.
Additionally, cost basis is essential to the tax equation in the inheritance of various assets; generally, cost basis of a taxpayer is the cost that he or she paid for the property. When an asset is inherited, the beneficiary typically receives a cost basis equal to the fair market value (FMV) of the property as of the date of the decedent’s death, rather than the value that the original owner paid for the asset. A step-up in cost basis minimizes the amount of capital gains realized when the inheritor sells the asset. Your tax and financial team can help you manage these tax considerations for your situation and prepare accordingly.
Perhaps the largest benefit you can receive from an inheritance is to put it toward your current debt and future savings. You can use some proceeds from your inheritance to pay off various liabilities (car loans, student loans, credit card debt, a mortgage, etc.). You may also consider using your inheritance to start or build an emergency fund for unexpected costs. The recommended amount of liquid assets to have on hand in the event of an emergency is three to six months’ worth of living expenses. Creating a budget that considers and accommodates your new inheritance can help you put all of these items into perspective.
An inheritance can also help you boost your savings for the future. If you have a retirement account of any kind, consider using your inheritance to contribute the maximum amount to these accounts, if you haven’t already. For 2015, the contribution limits for a 401(k) plan and an individual retirement account (IRA) are $18,000 and $5,500, respectively. Higher contribution limits are available for those over age 50, as well.
If you have children (or if you’re planning to have them in the future), you may want to dedicate your inheritance to a college education savings fund. There are a number of tax-advantaged education plans that can allow you to save money for your child’s education costs. With these plans, earnings are generally tax-deferred and may also be eligible for state tax deductions. Distributions are generally not subject to tax when used for qualified education expenses for a beneficiary, including tuition, fees, books and room and board.
With proper planning and open communication between family members, you can properly adjust to your new financial reality. By taking the initiatives listed above, you will have more time to figure out next steps, move forward in the right direction, and above all else, have peace of mind in knowing that your inheritance is being handled responsibly.